This headline explains more about how markets function than all of my finance textbooks from college combined:
This story from CNBC is from a few years ago but for some reason that headline has stuck with me. Here’s the entire quote from Buffett:
“People start being interested in something because it’s going up, not because they understand it or anything else. But the guy next door, who they know is dumber than they are, is getting rich and they aren’t,” he said. “And their spouse is saying can’t you figure it out, too? It is so contagious. So that’s a permanent part of the system.”
The reason I got into finance in the first place is because I was interested in the analytical nature of the business. The reason I stayed in finance is because I became fascinated with the behavioral nature of the markets.
That contagious, permanent part of the system Buffett mentioned is one of the reasons it’s so difficult to predict the path of the stock market.
You could make a compelling case right now that the U.S. stock market is insanely overvalued and set up to offer investors subpar returns from current levels for some time into the future.
The analytical side of my brain completely understands this argument. Admittedly, it’s an argument many intelligent people have been making for some time now and the market hasn’t agreed.
But the behavioral side of my brain wouldn’t be surprised if the stock market continued to charge higher despite above average valuations and strong returns since 2009.
Consider the housing market, which is on fire right now despite the pandemic. I have had multiple conversations with people over the past few months who have put their house up for sale simply because they learned they could get a higher price than they could have last year.
We couldn’t resist putting our house on the market with the prices we’ve seen other houses go for in our neighborhood.
I understand the temptation to sell high when you can get a much better price for your house than what you bought it for. But what about the other side of this equation?
Selling your home for a higher price may make you feel good but unless you’re downsizing or moving to a lower cost of living area, you’ll end up paying a higher price for the new home you move into.
This would be like selling Zoom because it’s up so much this year to buy Peloton shares (which have also risen considerably).
Yet this is just how markets work.
You see your neighbor sell their house for a higher price than you thought it was worth so you have to put yours up for sale too, right? You can’t watch someone else earn a premium price without taking part because FOMO is so enticing. You feel like you have to sell.
The same is true when it comes to buying stocks.
It’s possible the stock market could see a sustained downturn if the pandemic continues to get out of control, a vaccine is further away than expected or the economy experiences another setback.
I’ve lost my ability to be surprised in 2020 so this certainly isn’t out of the realm of possibilities.
But this realm of possibilities could also see investors completely ignore elevated valuations and send markets to the stratosphere because of ultra low interest rates, a potential vaccine, a possible post-Covid spending boom, a huge fiscal stimulus plan from our new president or a continuation of a rising stock market in the face of terrible news.
Watching other people get rich not only introduces career risk into investment decisions, it also gnaws at your psyche from a behavioral perspective. One of the biggest reasons FOMO exists is because it doesn’t seem fair.
Buffett is right that bubbles are a permanent part of the system in which we invest.
It wouldn’t shock me if the events of 2020 lead to a massive bubble from some combination of low rates and investors seeing people “dumber” than they are getting rich.
The 2 Variables That Drive Stock Prices